Behavioral pricing

What is the price? The question almost all of us ask before we make our buying decision.

Is the price right? That we do not know. But we want to see the price. Hence there are posted prices everywhere you go.

Price tags on the garments

Price labels on store gadget displays

Prices written on chalkboards in cafes and markets

Price lists (or even price books) published by B2B marketers

Pricing pages of webapps – presented in spectacular designs too

Marketers present prices and let the customers decide. No surprises.

Withhold the price information until after the customer consumed your product you are bound to shock them. We saw this with Uber’s dynamic pricing during New Year’s eve. We also see this in case of restaurants that charge “market prices” for their daily specials.

So we see published prices for everyone to see. We see several visual clues to tell us that the price is a “steal”. There are multiple price stickers, sales stickers, discount stickers. After all these, there is still one price – one price offered to everyone willing to make the purchase.

But charging a single price for a gadget or an entree does not maximize the profit a marketer can make. When you set a price for a gadget, there are

some who are willing to pay that price

some who would not buy at that price but would pay a lower price

some who would have gladly paid more but are happier with the lower price you are charging

It is easier to see that in case 3 you are giving away too much and hence losing out on profit.

In case 2, as long as you can produce the gadget cheaper than the lower price the customer is willing to pay you are missing out on that profit (however small it is).

By showing the same price to all you give up on these two profit streams.

If only you can show different prices to different individuals. Their own price that others cannot see. That is the holy grail of perfect price discrimination – First Degree Price Discrimination.

But we do not walk around with the prices we are willing to pay pasted on our foreheads, nor can a marketer show the price to one but not to others.

Until now.

What if we are indeed walking around with the prices we are willing to pay pasted on our forehead?

Well not quite but close. We may be doing close to that with our real life and online social media behavior. We saw discounts on our insurance for our real life behaviors. We have seen cases where Capital One was showing different interests rates based on your web browser. The next step is to not quite unimaginable. It is indeed possible to feed your Likes, Status messages, Photos, Locations, Friends etc into an algorithm that can give with reasonable certainty your willingness to pay for different goods.

The second part of the puzzle is how can that price be shown only to you?

The disruptions that are happening in the form of mobile payments and app based purchases are addressing that. You can see how easy it is to do that for online purchases. It is not a stretch to extend that to offline brick and mortar store purchases. Your price is shown only when you scan the barcode or read the RFID with your mobile wallet.

Everyone sees their price, that no one else can see. Taking us closer to perfect price discrimination.

It does not end there. Customers’ willingness to pay is not a fixed number. It is malleable. Once customers open their mind a little through their social media behavior, they are are also opening a control channel to the marketers. A channel that will help the marketers nudge customers to pay a higher price than what they would have otherwise would have paid.

It is a brave new world. World with NO price tags, price lists, pricing pages and posted prices of any kind.

Previously I wrote about the self-serve frozen yogurt stores in the context of creative packaging for better price realization. To refresh your memory, these self-serve frozen yogurt stores price and sell yogurt based on weight. They give you a container and ask you to fill it up with any one of the many flavors and toppings and then charge you one single price per unit weight.

The hypothesis I made then was that self serve option made customers spend more then they imagined they would. To be sure, it was based on a single visit to one frozen yogurt store.

Fortunately someone else collected data on the average customer spend in non-self-serve and self-serve frozen yogurt stores. Recently, the Small Business section of WSJ published data that is likely based on more than one visit,

With weight-based pricing, the average self-serve ticket is $6.32, compared with $5.61 at a traditional store, says a TCBY spokeswoman.

That is 71 cents more than traditional store. But questions remain,

First, is that increase all due to self-serve? The WSJ article calls it, “giving power to people”? Do we feel so empowered that we end up spending more? Is this because we feel less comfortable asking someone behind the counter for something we desire?

I can hear Customer service and “co-creation” evangelists jumping to big conclusion about the incremental profit from customer empowerment.

The answer is not straightforward. While the customer spend numbers may be based on TCBY observing years worth of data from its many stores, it is not correct to attribute causation to mere customer empowerment aspect. Data may fit one hypothesis but it can also fit any number of plausible hypotheses.

Another hypothesis is the one due to the shape of the container.

Shorter Wider Containers

The containers used in all these self-restaurant have a common pattern. They are all much wider than the containers we see in traditional yogurt stores.

As the research by INSEAD and by Brian Wansink indicate, we lose our ability to judge volume with wider containers. In addition wider bottom nudges us to cover the entire bottom and then build on it. It surely would feel odd to have yogurt in just one small area of wider bottom.

In addition we also do not know how much we spent. It is not that we are adding one scoop at at a time. We do not know the concept of weight. So by the time we take the container to the counter to pay, we have no idea of the price we are going to pay unlike traditional places that list the price right upfront before we make the decision.

The net result is we end up filling up lot more than what we likely want to eat and spend lot more than we normally would do at traditional yogurt places.

To say, “power to the people” (or “co-creation”) is the reason for higher spend is not correct unless someone can do multiple different experiments and run step-wise regression to find out what percentage of changes in average spend can be attributed to “the feeling of empowerment from self-serve”.

Second, should you as a small business considering yogurt store opt for self-serve model over traditional store? Talk to me, I can help you run a model to see if that is the case.

You have $X dollars to be used as promotional discount to increase your product uptake, i.e., maximize number of subscribers rather than maximize profit. You have two versions of your product, Silver priced at $19 and Gold priced at $49. How will you allocate the promotional dollars to drive most uptake? Will you discount your Silver version, Gold version or split between both?

Sidebar: I understand I have consistently advocated about profit maximization and not using price to drive volume. But let us assume you have a very good reason to do that and it is not permanent price drop but a controlled price promotion. May be you have a freemium model with a Bronze version at $0 and want to move most free customers to paying customers.

Consumer behavior research says, based on Prospect Theory (Kahneman and Tversky 1979), you are better off spending the promotional budget on discounting the lower priced version than the higher priced version. While rational economics states (assumed?) a $5 discount is the same regardless of the price, consumers look at $5 with reference to the base price. Consumers value $5 discount on $19 version more than then do the discount on the $49 version. So discounting your silver version maximizes new customers.

However there is an exception – when customers’ reference price (the price they expect to pay for similar products regardless of their economic value) is lower than the price you charge. Here the effect is reversed so you should discount the Gold version. If you are interested in understanding this case please write to me.

In either case, you are better off allocating the promotional budget to just one version and not dividing between two versions.

I was at Best Buy stores the other day and was looking at their cables. I was surprised to see HDMI cables being sold for $40-$80. Even a simple DVI to HDMI converter, which is useless without a cable, was priced at $30. The same cables from non-name brands are priced at fraction of the price online. In fact a quick search in the Internet shows stories since 2006 taking about alleged “price gouging.

I do not believe price gouging exists in a free market where customers have options and are allowed to make their own choice. But what explains the high price of these cables? It is the price flat screen TVs.

The first reason is the relative price that is rooted in behavioral economics. To a consumer buying this TV (or having bought one), compared to the price the pay or TVs, the price of cables look cheap. Consumers tend to think of price they pay in terms of percentages and not absolutes. This is the relative price. For a crisper description see this. $40 is a small percentage of $1000.

The second reason is the increase in reference price, which is the price a customer expects to pay based on their past experience. Having just paid $1000, customers are anchored to this price and are willing to pay $40-$80 on cables for these TVs.

Conveniently, Best Buy only stocks cables $40 or more taking advantage of these factors at work. However, Amazon.com stocks cables of every possible price. In fact for the TVs Amazon says, “customers also bought $6 HDMI cables”. Here even though customers might be willing to pay high price for cables, the presence of cheaper options decreases their reference price.

If you are a marketer, it is obvious what you should do with pricing. Price your complements as a percentage of the price of the primary component. Due to relative price and reference price effects, your customers will not mind paying high price for the complements.

If you are a buyer, be aware of relative price effects. The price you pay for accessories and complements should be looked at in isolation and not relative to the price of the primary component. In a consumer setup this can be handled by separating the two purchases in time. In a B2B set up, it can handled by having separate purchasing managers responsible for the primary component and secondary parts purchases.

Facing down economy, customers cutting expenses due to unemployment and overall drop in consumer confidence many small businesses face excess capacity, high fixed costs and drop in customers. One such business is Sensorielle spa in Boulder Colorado. For Sensorielle, or for any business, there were two options when they faced such steep drop in sales,

Cutting marketing costs is not a good idea especially during recession. For a spa the differentiation comes from telling a convincing story and making a value proposition to customers that the services are far better than a simple massage they could get from cheaper alternatives.

The talented staff are the most important asset to a service based business like a spa, without them there is no convincing value proposition. It will also be very difficult to hire them back when the economy turns around.

Price cuts are never a good idea especially when the service provided is valued highly by customers but they decide not to consume it because of changes in their wherewithal to pay. For a luxury spa, price acts as signal of quality and value. It is also very difficult to increase prices after price cuts.

Ms. Jewl Petteway, owner of Sensorielle spa decided to experiment with “Pay-What-You-Can” pricing scheme. The net is, there are posted list prices but customers are encouraged to pay “what-they-can”. The pricing also served as marketing message to bring back customers, especially long time regulars. A key point to note is that while this resembles “First degree price discrimination”, which is charging each customer their true willingness to pay, the “Pay-What-You-Can” is not aimed at capturing value.

Should this have worked? My hypothesis, when I first learned of this pricing, is that there are other ways to increase profits than leaving it up to the customer to pay. The customers do not always know the value they get. While the posted list price serves as a great anchor, “Pay-What-You-Can” tells the customers that the price is negotiable or that the list price is an upper bound the spa set but the true value is below that number.

M.Petteway published results from her experience in the Boulder Net LinkedIn discussion board. She talks about how few customers interpret the pricing plan as “pay what I want” and ask for high-end services even though they pay less than the posted prices. For any rational customer (Homo Economicus) whose goal is to maximize their utility, it makes sense to pay the minimum they can get away with. But that is not the only reason why customers are paying less for the services.

When a business has a list price and then says, “pay-what-you-can” it signals to customers, “you may value more but you don not have to pay the list price”. The list price is treated by customers as “full price”. Pay-What-You-Can ends up destroying value and decreasing the reference price in the minds of the customers. Even if there is not an explicit price cut, the signaling ends up decreasing customer willingness to pay.

My recommendation: I do not believe in leaving it up to the customer to pay for the services. I instead believe in segmentation and targeting. They should have offered multiple versions at different price points and with unbundled pricing that allows customers to self select themselves to the version that matches their willingness to pay. The classic example in services is salon pricing. Price discrimination is not about leaving it up to the customers to decide what they want or can pay, it is about giving them enough choices and nudging them to the version they are most likely to choose and profitable to you at the same time.

If we always made rational decisions that is based only on economic reasons the price we pay for products and services we buy should leave us feeling that these are worth more than it cost them. At the very least these two should match. The difference we perceive, between what the product is really worth to us and the price we paid is called the consumer surplus. But the problem with this is we are not all economists or rational number crunchers. I am going to exclude emotional decision making for this post and focus simply on our quantitative ability or the lack of it.

I do not mean our capabilities with numbers but our ability to assign a dollar figure to the value we derive from products and services. Imagine you have an hand held device that can read bar code and an LCD display. You read the bar codes of any product and it displays the value you will get. Then you look at the price and decide whether this leaves you a positive consumer surplus or not and decide whether or not to buy it. The value we get is our Willingness to Pay. We should be willing to pay any price up that and not more than that.

Unfortunately we do not have a device and even if there is one the device must not only work differently for each person since the value you get is different from mine and from everyone else but also work differently for the same person based on time and context.

There is no such device. So how do we know whether are not a product is worth the price we paid for it? We never will for sure. I have heard a simpler and better definition for consumer surplus, ” it is the size of the smile on our face after we buy the product”. If we kick ourselves for buying at a price obviously it means we paid too much.

The story does not end there, there are complexities like reference price, how marketing can increase our willingness to pay, how lack of value information (with no magic barcode reader) can artificially suppress our willingness to pay. There are emotional purchases in which we convince ourselves of higher willingness to pay or adjust our willingness to pay post-purchase to assuage our concerns of overpaying.

Now you know why microeconomics alone is not enough to define pricing strategies for marketers and the need for behavioral economics and behavioral pricing. I look forward to writing a few articles in behavioral pricing in the coming weeks.